September 2012

More capital sounds to most like a good thing, but the devil is in the details here, and we will likely not be happy with the unintended consequences. What we need is regulation with varying standards based on complexity and risk, and not necessarily the size of a financial institution in order to develop a realistic level playing field.

The most interesting thing to me is that at least one FOMC participant, possibly more, projects some pretty dramatic rate shocks in our future. Just using the graphs shown in the minutes it’s hard to tell exactly because the individual projections aren’t identified across each time period. At a minimum however one projection has the target changing by +125bp by the end of 2013. In 2014 things could get more volatile, again one projection could be as little as a +125bp change, or it could be as much as +275bp.

Stick to basic shock analysis using 100, 200, 300 and 400bp parallel changes. Evaluating anything different will get you into the business of trying to predict rate changes. And as we’ve seen from the Fed over the past eight months (see January, April, and September minutes), even these smart folks can’t nail down their prediction.

“While yesterday’s announcement is not unexpected, I don’t think you’re going to
find that too many community bankers are happy about it,” said Brad Olson,
president of Olson Research and Associates, a firm that provides asset and
liability modeling expertise for community banks. “Whereas the markets
expect the Fed to ‘do something’ many bankers believe the Fed has done all it
can do. Even lower long-term rates aren’t likely to further stimulate loan
demand; rates are already at historic lows. Actually the Fed’s message may
act as a catalyst for further risk-taking,” said Olson.

...when you have a limited amount of sample data, simple models have greater predictive accuracy than complex models.

More importantly, however, the real problem isn’t that risk management models can be gamed; it’s that they don’t work when the complexity of the model dwarfs the available data from which the model is estimated.

There’s a book called Interest Rate Risk Management that I’ve mentioned on this blog before. In it the author dedicates an entire chapter to “Income Simulation.” Essentially it’s an in-depth look at measuring IRR exposure using a future projection and then stress-testing or changing rates: i.e. earnings-at-risk. Throughout the book the author does a great job of presenting not only the benefits of using such measurements but the drawbacks as well. This chapter is no different. In fact the last part of the chapter labeled, “Disadvantages of Income Simulation,” lists no less than six very specific problems with measuring earnings-at-risk. The second item on the list is the following:

Assumptions can intentionally or inadvertently understate risk exposures …income simulation permits rate risk managers to reflect potential balance sheet changes into their forecast. This can be both a strength and a weakness…assumptions used in the simulation may actually mask some or all of the current rate risk exposure. (emphasis is mine)Chapter 3, Interest Rate Risk Management by Leonard Matz, 2003, Sheshunoff Information Services

Actually the potential impact of future assumptions is at the core of the static versus dynamic forecast debate. But “understating risk” and “masking current exposures”? What does this mean? How much of an impact can it have? More than you might think.

This was very clearly illustrated to us by a client’s recent forecast and IRR stress-test. Normally this client provides a budget projection to use as their base-case forecast (i.e. a dynamic forecast). It’s an aggressive balance sheet growth projection showing anywhere from 5 to 10% growth in various loan and deposit portfolios over the next year. The stress-test shows the bank is exposed to rising rates in the short-term. The shock up shows a potential decrease of -5.32% in the bank's net interest earnings. We also ran the stress-test using a static one-year forecast. The static forecast projects no balance sheet growth but rather projects a flat “static” balance sheet (only volume rolling off is replaced). After applying the rate shock-up we see a noticeably different result: a potential decrease of –9.65% in the bank’s net interest earnings; it’s almost double (see results below).

Many of you are probably looking at these results and saying, “so what?” It doesn’t look like that big of a difference. After all the latest interest rate risk peer data shows that the average Net-Interest Earnings at risk for banks $100M to $300M is around –8.2%. Is the difference here that big of a deal?

What if I told you this bank’s policy limit is –10.0%? Both measurements are within the limits, but one is clearly much closer to the limit than the other. What if I told you that while the bank’s commercial lenders were confident they would hit their targets (aren’t they always?), others on the management team weren’t so sure. The growth definitely combats the pressure on margin, but what if it doesn’t materialize?

In this case (as is the case with most of our clients) I think the static forecast is a much better stress-test. It helps eliminate many of the assumptions that can potentially “cover-up” risk.

Is stress testing a useful risk management tool for community banks or an empty regulatory exercise? Regulators and many experts argue that well-designed stress tests, scaled to community bank needs and capabilities, can be a very useful tool. But sometimes examiners can and do ask for stress tests that may not have much tactical value – or in some cases, any value at all – for community banks, experts say.

Risk management still has its weak spots, despite the valuable lessons banks learned from the financial crisis. Practitioners wonder if stopping the next blow-up is even a reasonable goal for the profession.